Europe’s emergency loan schemes stir fears of a debt trap

A view of the bar in the Movida restaurant located at the Naviglio Pavese canal in Milan, Italy

Michele Berteramo, owner of the Movida restaurant and cocktail bar on Milan’s Naviglio Pavese canal, had been about to spend 40,000 euros ($45,270) on renovations when the new coronavirus pandemic struck northern Italy. 

Instead he burnt through the cash keeping his business afloat during lockdown. Movida reopened on May 18, but is struggling to break even as crowds stay away from the popular nightlife district.

“We’ve been able to skip rent payments, but it can’t last forever … we are going to need bank financing to operate,” said the 46-year-old restaurateur.

Berteramo has tapped Italy’s emergency government guaranteed loan scheme to help pay his bills, but if he wants to press on with his renovation plans, he will need to take on even more debt, in a shrinking economy, to do so.

His conundrum is a long-term concern for governments and banks across Europe, which are rushing to prop up struggling companies, but are worried that the increased debt levels will hinder their ability to invest in growth.

Credit to non-financial companies in the euro zone hit an 11-year-high in April, European Central Bank (ECB) data show. According to our calculations, more than 290 billion euros of loans in government-backed lending schemes have been granted across the European Union’s four largest economies and Britain during the continuing coronavirus slump.

“If European Union growth only returns to its pre-COVID growth rate, after today’s sizeable shock, Europe will be left looking at a Japan-like future,” said UBS credit strategist Stephen Caprio, referring to years of stagnation in Japan as surging debt combined with deflation to hobble the economy in the 1990s and 2000s.

“European firms already had too much leverage. This will naturally stifle business investment”.

Underscoring concerns that such a scenario might become reality, central bankers are already flagging the twin threat of debt and deflation. “The high levels of public and private debt in the euro area as a whole … could trigger a dangerous spiral between the fall in prices and that in aggregate demand,” ECB Governing Council member Ignazio Visco said in a speech at the end of May.

Core debt to private non-financial companies in the euro area represented 165% of the region’s gross domestic product (GDP) at the end of 2019 according to latest figures from the Bank for International Settlements, compared to 150% in the United States. The European ratio is set to climb still higher following this year’s loan splurge.

The problem is particularly acute at small and medium enterprises (SME), which account for around two thirds of private sector jobs in the 27-nation European Union but lack the ability to directly access capital markets unlike their larger peers.

Policymakers are discussing options for getting more equity, rather than debt, into businesses but few countries have ready-made vehicles for funnelling mass investment into SMEs.

While several governments have set aside funds for capital injections into large companies, they are having to think up innovative options for smaller firms.

“The aid to businesses will need to be redirected from loans in Act One to part-equity … the choices are complex, costly and part of the political debate,” Bank of France Governor Francois Villeroy de Galhau said in an opinion piece in Le Figaro newspaper on April 24.

The European Union has estimated that companies will need 720 billion euros in solvency support in 2020 alone and aims to activate around 300 billion euros of investment through guaranteeing and supplementing private sector investment.

That could provide longer-term support for medium-sized businesses although there are caveats – priority will be given to companies that fit with the EU’s broader goals of improving digital technology and shifting towards a greener economy.

“It will be difficult to obtain these funds for traditional industries,” said Jose Manuel Gonzalez-Paramo, a former European Central Bank policymaker from Spain, adding that smaller businesses will be unlikely to attract much of this cash.

It is only “once they grow they’re on the radar. You can’t imagine a fund investing in bars for example”, he told us.

French investment company Tikehau Capital, which focuses on medium-sized companies, is eyeing opportunities.

“We are getting more and more calls, many from the 100% family-owned businesses in Spain, Germany, England,” said Mathieu Chabran, Tikehau’s co-founder.

“They are worried their leverage levels could double so feel it now might not be such a bad idea to let in a financial investor with long-term capital.”

Tikehau manages around 25.4 billion euros in assets – but there are a limited number of investors of that scale operating in the small-to-medium sector.

In Britain – which has one of the region’s most developed capital markets – financial lobby group CityUK estimates the level of equity raised by small and medium businesses in the past two years is 7.2 billion pounds ($9.00 billion). The group also forecasts that 32-36 billion pounds worth of loans taken out by companies using the government’s emergency loan schemes will be “unsustainable” by the end of the first quarter of 2021.

Backed by the Bank of England, CityUK launched a “recapitalisation” project to examine how private equity, insurers and pension funds could invest more into SMEs.

“This is a huge and complicated challenge,” said CityUK chief executive Miles Celic. “There won’t be a one-size fits all solution. We need a range of viable options … and many different types of investors.”

It is examining new types of instruments for encouraging SME investment ranging from straight forward share purchases to “profit participating debt” – a type of loan that is treated more like equity on a balance sheet and whose repayments would be linked to profits.

In France, central bank head Villeroy has said a similar instrument, known as ‘prets participatifs’, could be adapted to help SMEs.

Italy is planning to offer tax breaks both to small firms that boost their capital and to investors who offer up their cash to help such companies.

Fondo Italiano d’Investimento – a fund backed by the state lender CDP – is preparing to launch an 800 million euro pot to take minority stakes in Italian firms with revenues of 20-250 million euros.

Most such schemes and instruments will require a degree of government backing – although that in itself can be a problem.

Germany has set aside 100 billion euros for equity investments in troubled companies, but it has barely been touched to date. Banks have blamed Berlin for attaching too onerous conditions – such as controls on salaries – saying it is encouraging businesses to turn instead to more debt.

With lockdowns only recently starting to ease across much of Europe, bankers also say many companies, particularly SMEs, are unlikely to be focused on capital raising yet.

But as debt repayment holidays start to expire and the availability of emergency loans tails off, late 2020 and early 2021 is likely to be when companies will need the option of fresh capital.

“We need programmes to be launched as soon as possible so funds arrive in time,” said Carlos Torres, chairman of Spain’s second biggest bank BBVA at a conference put on by the country’s main business lobby last week.

“Coming late may, in many cases, mean not coming”.

Milanese restaurant owner Berteramo has used up his first 25,000 euro state-backed loan and is awaiting a second tranche which will be underwritten by the local region. “We’ve got nothing but debt right now … I am beginning to get a bit worried,” he said.

As things stand, the only simple way to raise more equity would be to take on a business partner, which doesn’t appeal. “The fewer people running a restaurant the better it is,” he said.

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